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How to Invest: Dogs of the Dow

For anyone looking to find a safe way to invest $1,000, stock-picking is most likely not the way to go. Trying to pluck individual companies due to rise is extremely difficult, and even the best market watchers and investors are wrong almost as often as they are right. However, there are some strategies for picking stocks that can limit risk and provide a chance for better returns than a mutual fund or broad ETF.

One such strategy is known as the Dogs of the Dow and was popularized by Michael B. O'Higgins in 1991 and later detailed in his book Beating the Dow. O'Higgins took the 30 companies that make up the Dow Jones Industrial Average and suggested inINTCvesting evenly across those 10 companies that have the highest dividend yields. The investor should then reset each year on January 1st, selling off companies that are no longer top ten in yields (or fell out of the Dow entirely) and buying up whichever companies moved into the void. The strategy, while imperfect (aren't they all?), still has some very valuable applications.

The issue with most stocks is that there's no guarantee they'll provide any sort of return. Companies' fortunes can rise and fall seemingly at random, and purchasing the wrong stock can mean lost money. However, dividends provide a chance to get a return on investment regardless of what the share value is doing. While dividends are no guarantee, they're still typically reliable enough to make an investment much safer in the long run.

The Dogs of the Dow is based on the simple principle that dividend yields are a better way of valuing companies in the Dow. While share prices can rise and fall based on a variety of market trends, yields will tend to remain consistent and, as such, can be depended on. In short, if you buy a company like Coca-Cola (KO) , the share prices will tend to even out and steadily rise over time, but the dividend will keep producing regardless of where you are in the market cycles. What's more, bigger companies tend not to move as much as small-cap entities. With well-established business models and markets for their products, companies on the Dow are very unlikely to experience too much volatility or major swings in share price.

Getting the Most Dividend for Your Dollar

Another feature of this plan is less definite, but still intriguing. It has to do with the nature of the dividend yield.

Companies typically express their dividends in terms of a specfic money value per share. And, for venerable, blue-chip companies like those on the DJIA, it's rare to see a major shift in said value. Usually just a few cents a share. What's more, it's almost always an increase. Big companies that have peaked out on growth and see limited increases in their earnings use dividends to stabilize their share price. Investors aren't getting growth anymore, but the dividend keeps them from selling the stock. As such, maintaining investor confidence that said dividend isn't going to erode after a few bad quarters or years is important. The circumstances that would lead a company of this size to substantially reduce its dividend would have to be pretty dire.

However, dividend yield is different. It's expressed as a percentage of the share price. In essence, what percentage of your investment can you expect back over the course of the year in the form of dividend payments. If the share price goes up, the dividend yield goes down. If the share price goes down, the yield goes up. The dividend itself hasn't changed, just its relation to the share price.

And that may be where the Dogs of the Dow strategy gains an advantage: you're getting the most dividend for your dollar. You're buying into these steady, consistent dividends at a time when they're available at the best possible price. This also means buying when the stocks are at relatively low prices, which itself can have benefits. While it's a mistake to see everything as being cyclical and assuming a stock that's currently down is bound to bounce back (they very often just fall even farther), it is true these sorts of blue chip companies tend to have stability and steady gains over time. Value-seeking investors are likely to notice that nice dividend yield and buy shares, which in turn leads to rising share prices. It's almost a built-in support level for the stock, buoyed by the investor confidence in the company's reputation and long history.

Sure, there will be times when even a venerable mega-cap on the DJIA just keeps sliding, but as often as not, one will probably find that said company will be more than balanced out by the other companies gaining or holding value. And, hey, even the losers will still probably pay their dividend. On the whole, the strategy presents an attractive value buy with relatively low risk and a stable dividend. It's not always going to work, but no strategy really does.

Imperfect Plan

In formulating the strategy, O'Higgins back-tested the formula and found that the Dogs of the Dow typically outperformed the market all the way back to the 1920s. However, promptly after unveiling his results in the early 1990s, the Dogs quickly reverted to under-performing, lagging the general market by about 2-3 percent for the next decade. One lesson to take from this is that data-mining and looking only at past performance is a flawed perspective, but many also believe that the strategy only stopped working for that period because of O'Higgins calling attention to it.

However, the returns over a long period of time still offer up some compelling evidence. From 1957 to 2003, the Dogs outperformed the Dow Jones by about 3 percent with an average return of 14.3 percent. However, focusing just on 1973 to 1996 garners more impressive results, with the Dogs offering total returns of 20.3 percent annually to the Dow's 15.8 percent.

In the end, investing in blue-chip stocks with strong dividends is a relatively safe strategy that's unlikely to blow up in one's face (though, as with any investment, there's always that chance). Moving forward, it's impossible to say with certainty what will happen, but investing in companies large enough to show relatively stable returns and that offer a strong dividend is a strategy that's unlikely to lose money and very possibly might create a portfolio that can beat the market.

The Dogs of the Dow

And, for those interested, based on the 30 companies currently listed on the Dow Jones, here's what the pack would look like:

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